CHAPTER 19

IS CASH FLOW KING IN VALUATIONS?a

Jing Liu, Doron Nissim, and Jacob Thomas

Contrary to the common perception that operating cash flows are better than accounting earnings at explaining equity valuations, recent studies suggest that valuations derived from industry multiples based on reported earnings are closer to traded prices than those based on reported operating cash flows. The question addressed in the article is whether the balance tilts in favor of cash flows when the following are considered: (1) forecasts rather than reported numbers, (2) dividends rather than operating cash flows, (3) individual industries rather than all industries combined, and (4) companies in non-U.S. markets. In all cases studied, earnings dominated operating cash flows and dividends.

Industry multiples are used often in practice, both to provide stand-alone “quick and dirty” valuations and to anchor more complex discounted cash flow valuations. To obtain a company valuation, one simply multiplies a value driver (such as earnings) for the company by the corresponding multiple, which is based on the ratio of stock price to that value driver for a group of comparable companies. Choices for value drivers include various measures of cash flow, book value, earnings, and revenues, but earnings and cash flows are by far the most commonly used. In the study reported here, we compare the valuation performance of earnings multiples with the performance of multiples based on two measures of cash ...

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